Actuarial Corporate Finance

Efficient Market Hypothesis

Asset prices reflect available information

Weak Form

Asset prices incorporate past prices and volume data

Semistrong Form

Asset prices incorporate all publicly available information

Strong Form

Asset prices reflect all public and private information

Evidence Against EMH

Returns higher in January and Fridays

Anomalies

IPOs overperform on day one then underperform

Idiosyncratic Risk

Firm-specific and diversifiable risk

Systematic Risk

Market-wide risk affecting all firms

Risk Premium

Additional expected return for taking on systematic risk.

Volatility (σ)

Measures total risk or variability in returns.

Beta (β)

Measures systematic risk

Market Portfolio Beta

Equals 1.

Effect of Correlation

Negatively correlated assets reduce overall portfolio risk

Efficient Portfolio

Portfolio on tangent line from risk-free rate to efficient frontier

Sharpe Ratio

(Expected portfolio return – risk-free rate) / portfolio volatility.

Short Sale

Selling a borrowed stock with intent to repurchase later at a lower price.

CAPM

E(R) = rf + β × (E(RM) – rf)

Frictionless Market

No taxes or transaction costs

Rational Investors

Hold only efficient portfolios.

Homogeneous Expectations

Investors share the same beliefs about risk and return.

Capital Market Line

Shows risk-return tradeoff for efficient portfolios (market + risk-free asset).

Security Market Line

Depicts expected return vs. beta for all assets.

Cost of Capital

Expected return required by investors

Debt Cost of Capital

Expected rate of return on bonds (rd = y – p × L).

Cost of Project Capital

Estimate using similar unlevered firm or comparable asset cost of capital.

Enterprise Value

EV = Equity + Debt – Cash.

Unlevered Cost of Capital

Weighted average of cost of equity, debt, and risk-free return adjusted for cash.

WACC

Weighted average cost of capital

Relevant Cash Flows

Include revenues, costs, infrastructure, taxes, and product cannibalization.

Project Cash Flow Formula

Sales – Costs – Depreciation = EBIT – Taxes = Net Income + Depreciation – CapEx – ΔNWC.

Stock’s Alpha (α)

α = E(RS) – rSML

Disposition Effect

Holding losing investments too long.

Herd Behavior

Following other investors’ actions.

Investor Biases

Lead to negative alpha on average.

Mutual Funds

Typically destroy value due to overtrading.

Value Stocks

High book-to-market ratios

Momentum Strategy

Buy stocks with high past returns.

Data Snooping Bias

Finding false patterns through excessive testing.

Small-Minus-Big Portfolio (SMB)

Long small-cap stocks, short large-cap stocks.

High-Minus-Low Portfolio (HML)

Long high book-to-market, short low book-to-market.

Prior 1-Year Momentum

Buy top 30% of prior-year performers, short bottom 30%.

Fama-French-Carhart Model

Adds size (SMB), value (HML), and momentum (PR1YR) factors to CAPM.

Leverage

Ratio of debt to equity

MM Proposition I

In perfect markets, firm value unaffected by capital structure.

Leveraged Recapitalization

Borrowing to repurchase stock or pay special dividend.

MM Proposition II

rE = rU + (D/E)(rU – rD)

Interest Tax Shield

Interest payments × corporate tax rate

MM with Taxes

VL = VU + PV(Interest Tax Shield).

Bankruptcy

Occurs when firm cannot meet debt obligations.

Chapter 7

Liquidation